Technology

Tech's Best Hope: Pockets of Prosperity

March 14, 2002

Ask PeopleSoft Senior Vice-President Michael Gregoire about the technology industry's prospects in 2002, and he says it's looking like a year in the doldrums, with little real growth. "There's still a lot of caution and scrutiny going into capital expenditures," says Gregoire, who heads the business software company's 3,300-person consulting unit.

Ask Gregoire about his own company, however, and he says PeopleSoft (PSFT) will prosper this year. In fact, the company announced in early February that it expects operating margins to hit 18% in 2002, up from 15.4% in the fourth quarter of 2001 -- and 10.7% the year before. Even with sales growing nominally, PeopleSoft should post higher profits.

So which Gregoire knows what he's talking about? Both. Corporate spending on many sectors of information technology will likely stagnate or decline in 2002. Hardware and communications equipment will probably take the brunt of that hit, while software and services will do O.K. Average it out, and the persistent cloud over tech may have a silver lining, as pockets of prosperity prove sufficient to offset the parts of the industry that will remain in a slump.

YESTERDAY'S HOTSHOTS. "It's not, 'Go long everything in technology.' There are pockets of demand, but it's not software across the board. It's not semiconductors across the board. It has become a company-specific call within each given sector," says David Readerman, growth strategist at San Francisco investment bank Thomas Weisel Partners.

At the same time, the slow-forming recovery will likely redefine the tech sector. One-time go-go products such as databases, desktop PCs, and productivity software will shift into more subdued growth patterns, while newer types of software and IT services may grow at a far faster clip. That means niches within niches are now developing. Many analysts are wary of storage-hardware maker EMC (EMC) but love storage-software plays such as Veritas (VRTS).

The upshot? Oracle's Larry Ellison and Microsoft's Bill Gates might end up looking more like the heads of General Motors and General Mills than CEOs of the swiftest players in the game. The tech slowdown, now approaching the end of its second year, "is definitely a sign of the maturing of the industry," says John Rutledge, manager of Evergreen Technology Fund.

"This year, the entire industry is scrapping for only $19 billion in additional revenues"

Without a doubt, the rest of 2002 will be a period of slow growth. A Mar. 11 Merrill Lynch survey of 100 chief information officers at major companies found them shifting their expectations of a tech-spending recovery out of 2002 and into early 2003. According to Peter Kastner, chief research officer at tech consultancy Aberdeen Group, total tech-sector revenues -- including hardware, software, and IT services -- will bump up from $446.1 billion in 2001 to $465.3 billion in 2002, an increase of 4.3%.

That excludes heavy-duty telecom equipment such as switches and backbone routers, which likely would have dragged down the figure. For sure, it's an improvement vs. the real decline in tech spending during 2001. But such an increase would be tiny compared with the mid-double-digit sales leaps of the late 1990s and 2000. "This year, the entire industry is scrapping for only $19 billion in additional revenues," says Kastner.

LIFELESS SECTORS. In some corners, those battles are already drawing blood. Two sectors that have provided a huge stimulus for the tech sector during the past two decades -- PCs and cell-phone handsets -- remain dead in the water. According to a report released on Mar. 12 by Dataquest, global sales of handsets fell in 2001 by 3.2% -- their first-ever decline. Likewise, unit PC shipments fell by 5.1% in 2001, according to IDC.

Early indications have emerged that PC sales growth might get back into the black in 2002, driven by laptops. And handsets should also return to single-digit growth as roll-outs of new wireless-data networks spark some sales.

Still, the new reality feels like a screeching halt compared with the swift growth of past years, according to Evergreen's Rutledge. By his tally, handset sales exploded at an average annual clip of about 50% in the 1990s. And unit sales of PCs swelled 18% annually for the past two decades. Now, the markets for both of those products appear to be largely saturated. This is bad news not only for the companies that have ridden those devices to prosperity but also for lots of "downstream" component makers that have thrived until now.

SEARCHING FOR GROWTH. Everyone from chip manufacturers such as Texas Instruments (TXN) and Analog Devices (ADI) to chipmaking-equipment suppliers such as Applied Materials (AMAT) might feel the pain until innovations in hardware or software create a need for businesses to replace their stock of PCs and individuals to seek new phones. For now, though, there's no growth engine to take their place. "These products consume a lot of semiconductor components and are sold in the hundreds of millions," notes Rutledge. "We don't see any electronic product right now that will have the scale of either of those."

Microsoft's push to get customers to upgrade to Windows XP may be running out of steam

With the economy still walking a tightrope, that's also true for many types of basic software, such as Microsoft Office and Oracle database software. These programs have already reached a degree of sophistication where newer versions offer only marginal improvements, so many businesses hold off on upgrades. On Mar. 13, Oracle (ORCL) announced that its profits fell by 13% and that gross sales fell by 20% for the third fiscal quarter of 2002 as it struggled to sign up new customers. And influential Goldman Sachs analyst Rick Sherlund downgraded Microsoft (MSFT), after saying that he believes the software king's push to get customers to upgrade to Windows XP has run out of steam.

Those problems are minor compared with the challenges facing the big telecoms. While the Securities & Exchange Commission is investigating possible accounting irregularities at two of the biggest long-distance players, Qwest (Q) and WorldCom (WCOM), spending on telecom equipment continues to plunge. That comes on the heels of a spate of high-profile bankruptcy filings by telecom carriers such as Global Crossing and 360Networks -- not to mention disappointing results at Williams Communication Group (WCG) and Level Three (LVLT). Lucent (LU), Nortel (NT), and Cisco (CSCO), among other suppliers to the big telecom market, remain far from optimistic. "It's an industry in nuclear winter," says Aberdeen Group's Kastner.

QUICK RETURN. Beyond those trouble spots, however, the tech sector isn't looking too bad. According to Aberdeen's projections, revenues in the IT-services business will grow from $173.9 billion in 2001 to $183.7 billion in 2002, a 5.6% clip. And software sales will climb from $93.7 billion to $100 billion, a 6.7% rise. That compares to a mere 1.7% increase projected for hardware, from $178.4 billion to $181.4 billion.

Analysts say companies are planning to continue spending on advanced software that can optimize their operations. More often than not, with that software comes IT services -- systems integration -- from companies such as IBM (IBM) and Accenture (ACN).

Big systems integrators like IBM and EDS enjoy growing backlogs

Customers' continued willingness to spend is due, in part, to the fact that software used in enterprise resource management (ERP) and customer relationship management (CRM) quickly pays for itself. "We have seen that the ERP space is one of those areas where there is a proven return on investment," says Thomas Weisel's Readerman, who favors SAP as a good pick in the sector. According to the Merrill Lynch CIO poll, ERP and CRM currently rank No. 1 and No. 2, respectively, among the software products that companies are buying during 2002. This popularity is a big plus for sector leaders such as PeopleSoft, SAP (SAP), and Siebel Systems (SEBL).

The more of these ERP and CRM systems that need to be installed, moreover, the happier systems integrators are. According to Aberdeen's Kastner, big players such as IBM (IBM) and Electronic Data Systems (EDS) enjoy growing backlogs of work in these areas. Add to that the lengthening life cycles of PCs, servers, and most other types of hardware, and the decision to dedicate more money to software becomes a no-brainer.

INEVITABLE RECOVERY. Other software sectors that caused barely a blip in past IT recoveries will likely play a much bigger role in the coming rebound. Business-analytics software, which allows companies to gather all the information about themselves on their computer systems and analyze it to optimize efficiency, is set to soar, says Vincent Muscolino, a managing director at Cambridge (Mass.) investment-counseling firm David L. Babson & Co. As just-in-time manufacturing spreads, this type of analytical software is becoming more important. "Dell keeps two hours of inventory. Therefore, if Dell's supplier's supplier has a plant fire, you want to know about that, because this could back up the assembly line tomorrow," explains Kastner.

A slight recovery in tech has also become inevitable due to the huge cuts in inventories and overhead that so many producers have made. "Companies such as Sun and EMC (EMC) have lowered their break-even points considerably," says Muscolino. He figures that EMC used to need to pull in $8.4 billion in revenue a year to break even. Now, it needs only $6 billion, he figures. Further, Muscolino points out that even though the business of legacy software makers has slowed, they still enjoy stellar profits. "Oracle has managed to maintain 30% margins in an awful economy," he notes.

More efficient production technology should boost chipmakers' bottom lines

And coming off a horrific bottom, the semiconductor industry has bounced back. January orders were up 49% vs. the same month a year ago, according to figures from the Commerce Dept. Chipmakers are also about to reap the full benefit of more efficient production technology that should boost their bottom lines significantly. Stronger chip orders are particularly good news, since they usually portend a recovery in the rest of the hardware sector.

SET UP FOR A FALL? To put it in perspective, this year's uptick in the chip business will likely return many companies only to the revenue levels they enjoyed in 1997 and 1998. The industry may not see 2000 production levels for some time. But chipmaking technology keeps improving -- "manufacturers continue to pack more circuits on a chip," says Evergreen's Rutledge -- paving the way for a rebound when consumer and business demand returns.

None of this may launch a significant tech rally on Wall Street. If anything, many analysts fear that the market has priced in a recovery-and-a-half -- and set tech stocks up for disappointment. A lot also depends on the global economy: If Japan's funk drags the rest of Asia down with it, all bets on a tech recovery could be off. "There is value in some of the technology names, but there is no reason why this sector will realize this value until the business community starts to spend on technology in a big way," says Milton Ezrati, senior economist at Lord Abbett & Co.

For now, a big boost in overall tech spending looks unlikely. And when it does arrive, don't assume that past winners will be leading the pack again. By Alex Salkever